Financial Tip Friday: Mortgage Interest and Taxes

Last week I updated an old post that I had written earlier in the year about paying off the mortgage vs. savings. The title should’ve read paying off the mortgage vs. investing because savings really isn’t what I do. I mean I save, but it is for retirement. Anyway, that post, along with a long weekend with friends at a wedding got me to thinking about where I am in life, at least financially, and I stated that I feel a decade behind most people because of how late I started on getting my financial act together. Better late than never.

Between these two posts I got into a conversation with a couple of colleagues about mortgages, savings, and the like and it is a conversation I have had with other people. The basic conversation goes like this:

Me: When we bought our house I made sure I got a 15 year fixed loan so I could pay off debt faster. I am even looking to refinance to an even lower rate and possibly a 10 year loan.

Them: Don’t you deduct your mortgage interest? If you pay off the loan you will lose your biggest tax deduction.

Me: Yes, that may happen but I don’t care about the deduction. I want the debt gone.

Them: Why wouldn’t you want to keep the deduction?

Me: We go into a large conversation about my thinking about the mathematics of it.

At the end of most of these conversations I feel like I am ramming my head against a brick wall because people who own homes can’t fathom not giving up their mortgage deductions.

I don’t expect to change anyone’s minds I just like the verbal sparring, but the math for me on this doesn’t work. And the larger argument about keeping a mortgage around for a long time doesn’t work because of a tax break. Only about 27% of tax filers actually itemize their tax deductions anyway. Considering that 63% of Americans own homes there is a hug gulf between those that take the deduction and those that own their own homes. Here is my mathematical logic at not caring about the deduction.

Mortgage Interest Scenario

Let’s say you have a house that you bought for $200,000 and you put 10% down leaving you with a mortgage of $180,000. Let’s say your interest rate is 4% and your monthly payment is $837 per month. About $600 is interest (I know it is more…but I like round figures). That is $7200 a year to deduct.

Considering the standard deduction for a married couple of is $12800 you still need at least $5000 more in order to take the deduction. Now you can get there by deducting property taxes, state taxes, etc. Anyway, let’s say you get there and your Adjusted Gross Income is $100,000 between the two of you. You are in the 25% tax bracket. Let’s say the mortgage interest, real estate taxes, and state taxes give you total deduction of $15,000 reducing your AGI to $85000. You have just saved yourself about $3700 in taxes.

As someone who has paid the IRS a few thousand dollars each year for the past couple of years I can appreciate reducing my tax bill by as much as I can. That is GREAT! Right?

Problems with this scenario:

Your tax deduction isn’t that much.Truth is you only saved yourself about $500 in taxes because the standard deduction would’ve reduced your Adjusted Gross Income about as much as your deductions. You might respond by saying I would have more in deductions and that would reduce my bill further. That may be true. Let’s say you have $10,000 more in deductions you would’ve reduced your tax bill by about $3000 total and it would put you in a lower tax bracket. That is great.However, the mortgage interest deduction goes down over time because of the interest paid on the house. You might be only to take the mortgage deduction for say 10 YEARS of the loan, which let’s say saves you $30,000 in tax payments, but keeps the loan extended for much longer.

Tax savings don’t equal mortgage interest savings over the life of the loan. Let’s say that in this scenario you could actually refinance your loan to a 20 or 15 year loan without much of a problem. However (and I have had this conversation on more than one occasion), you don’t want to do so because you will lose the tax deduction. Somewhere along the way I think this person(s) must have had their brain removed. Because they aren’t calculating the BIGGER savings they would get if they went to a shorter loan in terms of interest. Let’s say if you reduced the length of the loan by 20 years you could only take the mortgage deduction for a year, thus saving you only $3000; whereas the other person could do it for 10 years and save about $30,000 in taxes. Again, good for them. However, that person with a 30 year mortgage will pay almost $135000 in interest over the life of the loan; whereas, the 20 year mortgage will pay only $75000. In other words, you are basically trading $30,000 for $60,000 (135-75,000=$60,000). The math doesn’t work. You save more by having a larger mortgage payment over a shorter period of time than taking a tax deduction every year.

People don’t factor in the idea of risk. For those people who want the mortgage interest and extend the life of the loan for a tax break they aren’t taking into account risk. What happens if you lose your job? Your kids need medical care? You need to pay for college? By taking the mortgage interest you will have a lot less equity in your home that could be available to you if you need it. Now, I am NOT saying take a home equity loan. A house isn’t an ATM. You shouldn’t use it to pay for things that you should be saving for (e.g. a trip, a car, whatever). But there are times when you might need it to finance things like home improvement or if you get into a jam financially. It can be a quick holdover, but I don’t recommend it. Having a mortgage around longer to take the deduction doesn’t allow for a much equity build-up as you would for a shorter term loan.

The Bottom Line: I know there are more factors embedded in this scenario. That could involve kids, home improvement, and the like, but the point I am ultimately making is that keeping a mortgage around for a tax break, in my opinion, is just plain dumb. Mathematically it doesn’t work. If you make another argument like you need the extra money for investing (e.g. the advice of Ric Edelman), paying for school, home improvements, taking care of parents and/or family that makes a lot more sense to me.

Your mortgage interest deduction is one of the holy grails of politics. No politician wants to touch it because it is supposedly so important to people. The problem with that logic is that most people, even homeowners, don’t take the deduction, the deduction only lasts a few years, and keeping the mortgage large and around for a few years actually costs more in interest in the long run than tax savings.

Solution: If you can financially swing it (and only if you can financially swing it) get a shorter-term mortgage with a lower-interest rate and don’t worry about the deduction. It isn’t worth that much.